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Inflation is Making a Come Back: What Does that Mean?

The Consumer Price Index, which measures inflation, crept up in January

Higher inflation can mean higher interest rates

Higher interest rates can also depress stock prices

6 min read

Prices for a wide array of consumer goods and services rose unexpectedly in January, sparking new concerns about inflation.

Something called the Consumer Price-Index (CPI)–which gauges price increases for a host of items including cars, clothing, gas, even breakfast cereal–rose 0.5% in the month .

So what does the CPI have to do with you? We explain it.

What’s the CPI?

The Bureau of Labor Statistics (BLS), which is a division of the Department of Labor, compiles a monthly report about prices, called the Consumer Price Index, or CPI. While it looks at price changes throughout the country, it focuses primarily on changes in densely populated urban areas.

At its most basic level, the CPI measures inflation, which is an increase in the cost of goods and services. (Another measure the BLS uses is something called the Producer Price Index, which calculates the cost to industries to produce their goods and services.)

The CPI examines prices for a basket of goods including thousands of items in various geographies, including milk and coffee, rental and housing prices, televisions and toys.

OTHER GOODS AND SERVICES: Tobacco and smoking products, haircuts and other personal services, funeral expenses.

So what exactly happened?

The CPI increased in January for a broad category of goods and services. Some notable increases include energy, which jumped 3%; Clothing, which rose 1.7%; and medical care, which jumped 0.6%.

But some areas showed a decrease in prices, including natural gas services and electricity, which fell 2.6% and 0.2%, respectively, according to the BLS.

Why do people freak out about interest rates?

It’s complicated, but think of the economy as an interconnected ecosystem. When conditions change for one indicator, it’s like they’ll change for others. Last week, market indexes fell into correction territory, in part because of fear that inflation is on the rise.

Investors tend to worry about inflation, because it can mean that interest rates will also go up in response. Here’s why: Something called the Federal Reserve, which is the nation’s central bank, sets monetary policy–which includes how much money is flowing into the economy through the banking system. One way it controls the money supply is by adjusting a key underlying interest rate, called the federal funds rate, which affects the cost of borrowing money between banks.

Think of the economy as an interconnected ecosystem. When conditions change for one indicator, it’s like they’ll change for others.

That interest rate underlies many other interest rates that affect consumers, including mortgages, credit cards, and car loans. And the Fed raises it to decrease the money supply, and lowers it when it want to increase the money supply.

What impact does inflation have on the economy?

In 2008, as the financial crisis began in the U.S., the Fed lowered its interest rate to near zero percent. It did that to increase the flow of cash in the economy, and to spur borrowing and spending by consumers.

Over the past couple of years, however, as the economy has recovered, the Fed has raised its benchmark interest rate, aiming to get back to more normal levels, typically between 2% and 5%. The federal funds rate is currently between 1.25% and 1.5%.

But the Fed also bolsters interest rates when it fears the economy may be going into overdrive, and growing too quickly. One indicator that it looks at is inflation. And it has set as its goal for inflation at about 2%. If there are signs inflation will go much above that, the Fed is likely to raise interest rates to apply the breaks on the economy.

The Fed is likely to increase interest rates again in 2018, to get back to normal rates and to combat signs of inflation, experts say.

“The worry of the markets is not that inflation is becoming a big problem, … it is that the Fed is now forced to play catch up” by increasing interest rates, Peter Boockvar, chief investment officer at Bleakley Advisory Group, told CNBC on Wednesday.

How do higher interest rates affect the market?

Higher interest rates can increase the cost of borrowing for businesses, and that can eat into earnings for businesses, including public companies whose stock consumers may own. That in turn can cause stock prices to fall.

Higher interest rates can also increase the appeal of bonds, which pay a fixed percentage of interest to investors. As rates go up, the yield on many types of bonds also increases. The yield, or percentage of interest paid, on the 10-year U.S. Treasury–one of the benchmark bonds offered by the U.S. government–rose to 2.89% on Monday, according to Bloomberg.

That’s an increase of nearly 0.5% since the beginning of 2018.

Jargon hack! Seasonally adjusted vs. unadjusted prices

Now that you know the basics of the CPI, here’s something else to think about. The CPI also shows statistics for seasonally adjusted and unadjusted data.

Here’s what that means.

Different seasons can show spikes in economic activity. Think of all the things you do in the summer: you may go on vacation with your family or loved one, for example, and might visit a resort or some other travel hot spot, and spend some of your hard-earned cash.

And that amounts to increased economic activity in that region. But the summer ends, and the workers who staffed the boardwalk pizza stand or ride concession go back to school, and the stand closes for the season.

Similarly, the winter months can create a huge bump in oil consumption to heat houses and apartments. Or storms, like the recent hurricanes, can cause a temporary drop in economic activity. The seasonally adjusted data make allowances for those economic spikes and dips, and essentially smooth out the numbers.

While economists look at both figures, the seasonally adjusted numbers can give a better idea of economic trends, according to the BLS. (The 0.5% increase for January is seasonally adjusted.)

Economists also tend to focus on the core inflation number, which strips out energy and food–both considered to be volatile sectors of the economy. Core inflation rose 0.3% in January, which was the largest increase in a year, according to Reuters.

12-month percentage change to CPI, as of January, 2018. Data is not seasonally adjusted.

So what does this all mean?

That 0.5% jump up in January may not seem like a lot. It’s just one month, after all. But it’s more than double the 0.2% increase recorded in December, 2017, according to the BLS.

For now, the DOL calculates the average annual rate of inflation to be about 2.1% for 12 months from January 2017 to January 2018.

We’re still a long way from runaway price increases, such as happened in the 1970s, when double digit inflation was common. But January’s increase has plenty of financial experts paying attention.

“Given the recent roller coaster ride in equities was sparked in good part by inflation fears accelerating rate hikes, the latest inflation data will be seen as increasingly important and telling, to date,” Lindsey M. Piegza, chief economist at Stifel Fixed Income, wrote in a research note, according to Reuters.

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